Understanding Debt Ratings

The Moody’s rating is based on statistical calculations of a company’s likelihood of default. The chart below shows the Moody’s Debt Rating system along with the data that Moody’s has calculated for the default rate of bonds that defaulted within one year of having a given rating for all companies between 1970-2001.

Looks pretty good but these probabilities are only for within 1 year of the company attaining a specific debt rating. Most debt is issued and held over several years, it is important to understand the longditudinal view, or cumulative probability, of default over an extended period of time.

Default Rate

The following graph shows the probability of failure over 5 to 20 years.

Now you can see why C-grade debt is almost certain to default and B-grade debt is roughtly 50-50. You may as well play black or red at roulette than “invest” at that level.

Degradation Rate

If you are willing to watch an investment closely you can exploit the fact that debt ratings change over time as a specific situation deteriorates. Moody and other rating agencies will downgrade an investment progressively on its way to default. Since lower-rated debt pays a higher yield than higher-rated debt, investing in lower-quality debt presents an opportunity to make more money in exchange for the higher risk that you are taking.

According to Moody, the average time to default of a B-rated company is about 60 months. The downgrade curve, as calculated by Moody, is shown below. But remember that because this is an average, 50% of situations will deteriorate faster than this! Is the risk really worth a few extra percent yield?